SD County Pension Boosts Leverage

This is probably not a good idea:

The San Diego County Employees Retirement Association has adopted a new asset allocation that adds leverage to the $7.2 billion fund, Pensions & Investments reports. The leverage brings the total target allocation to 135 percent.

Pension funds are supposed to be boring, long-term investors. Not SDCERA. Taking on leverage is not a sure, safe way to save money for retirement. It is an aggressive, high risk strategy. It means you are essentially wagering more money than you have. Ask Lehman Brothers how that feels.

Leverage is a way of boosting returns by taking on more risk. The net expected return from this new strategy is now 10 percent (up from 8.25 8.5 percent), which is supposed to add an additional $1 billion over the next 10 years. But that’s if — and it’s a big if — if everything goes as planned.

A few years ago, the flavor of the month was hedge funds. Investment guru David Deutsch plowed 20 percent of the fund into hedge funds, including winners like Amaranth, which imploded when a single trader lost $6 billion in a bad bet on natural gas prices, and WG Trading, whose managers were arrested for fraud.

Instead of taking its lumps, however, SDCERA has spent two and a half years suing to get its money back from Amaranth. A federal judge in New York threw out SDCERA’s lawsuit against Amaranth today, but the pension says it will appeal.

Well, they don’t have Deutsch to blame anymore. He got booted out last year when the fund lost 25 percent. The board decided to outsource his job to Lee Partridge, a guy who didn’t even apply for the job and who stands to earn as much as $1.2 million.

2 comments

Many parties are involved in a pension investment decision, notably staff, the consultant, and the board. The decision to run large cap domestic stocks as an S&P enhancement using hedge funds and S&P swaps traced back to a prior regime at SDCERA. The alpha engine was in place, but smaller, when I arrived in 2004, as was the investment in WG Trading, BTW. With the support of the consultant (Rocaton and later Albourne Partners), the exposure was increased to about 19%. Albourne praised and supported this structure throughout (but they are still retained by the fund.) The board understood the reasons for the investment based upon the difficulty of earning excess return from active management of large cap domestic stocks. The alternative investment would have been the S&P 500 directly and would have suffered huge losses in any case.

The “alpha engine” and “portable alpha” so much disfavored at this time are not arcane or unusual despite what some trustees keep saying. Virtually any diversified fund with an investment in the S&P500 stocks and an allocation to hedge funds has an “alpha engine.” The difference is in the accounting and accounting does not drive or change realities, it only “explains” them. The alpha engine is just a way of explaining investments that are made as a matter of course by pension funds. So, the ridicule of the alpha engine is ridicule of an accounting explanation not the reality because the reality is the same for all these funds.

Bridgewater Associates promoted the idea of risk parity, the idea of leveraging asset classes to the same risk level as equities. The idea is to leverage fixed income up to provide some protection in down markets. The idea was presented to the board innumerable times during my tenure. This leveraging within an asset class does not enhance the portfolio mix in terms of risk and return. The tradeoff of risk and return using leverage in fixed income is suboptimal and is dominated by better unlevered mixes on the efficient frontier. This comes about because the only relevant feature of leverage for optimization purposes is the cost of funds. In short – a fund can reduce risk more efficiently by changing the mix of unlevered asset classes than by using leverage. However, leverage has the virtue of providing some downside protection at a realistic level for SDCERA.

Looked at through the lens of option theory: SDCERA has purchased some downside protection at the cost of funds for the portfolio. This is fine because it would have been very nice to have lots of Treasury exposure over the last debacle. Even so, the strategy is clearly fighting the last war, not the next one. One might say that the cost of funds will be a drag on performance going forward, unless there is another credit driven recession which seems all but impossible in economic terms